You might have travelled to the US or Australia and might have exchanged your Indian Rupee for US dollars or Australian Dollars. So you must have had your Exchange Rates experience in practical. You should understand how they work. Or you must have heard a financial reporter say on the business news that the Rupee has fallen against the US Dollar. Thus to understand all these you need to understand the functioning of the exchange rates and factors affecting the values of currencies across the globe.
Evolution of Exchange Rates
For decades the currencies worldwide was trade on gold. That means any paper currency issued by any government represented real gold of an amount held in the government vault. After the 2nd World War all the countries based their currencies on the US Dollar. The value of other currencies against the dollar was based on its gold value.
Unfortunately the Dollar suffered due to inflation and other currencies become more stable and valuable. As such the US government could no longer pretend about the worthiness of the Dollar and ultimately the value was reduced to almost half.
The Gold Standard was removed in 1971. Thus the value of the dollar was no longer represented by the real amount of gold but by the market forces.
Today the US Dollar still dominates the currency market and many Exchange Rates are determined in terms of the Dollar. The US Dollar and the Euro account for 50 per cent of the world currency transactions.
The Cost of Currency
Domestic currencies are important to the way the economies functions. They permit to express the value of items across the globe. Exchange Rates are needed because one country’s currency is not accepted by another country as the currencies are different in all the countries. For e.g. one cannot walk into some store in Britain and purchase goods with the Indian Rupee. For that a person has to visit a bank and exchange the Rupee for British Pound. Exchange rate thus simply is the purchase of one currency with another currency.
Methods of Currency Exchange
There are 2 methods of currency exchange rates the fixed and floating exchange rates. The currency in a floating market is determined by buyers’ willingness to pay. This is determined by the demand and supply, foreign investment, inflation, ratios of import and export and various other economic factors. This system is not perfect in case of economic instability and inflation.
In the pegged exchange rate system the exchange rates do not fluctuate. To maintain a stable pegged rate the Central Banks must have enough cash reserves to meet changes in the demand and supply. Developing economies can adopt this system to prevent unstoppable inflation. Thus if a country does not take proper care of its currency it might turned to be useless.
Currencies were traded in terms of gold value of the dollar for decades in the past which marked the beginning of Exchange Rates. But inflation in the US economy reduced the value of the Dollar and removed the Gold Standard. Even today many currencies are determined in terms of the Dollar. The rates can be pegged or floated.